AGENCY:

Internal Revenue Service (IRS), Treasury.

ACTION:

Notice of proposed rulemaking and notice of public hearing.

SUMMARY:

This document proposes revisions to examples that illustrate
the controlled group rules related to regulated investment companies
(RICs). These proposed revisions resolve an issue with how the controlled
group rules should be applied in connection with the RIC “asset
diversification” test. This document also provides notice of
a public hearing on the proposed regulations.

DATES:

Written or electronic comments must be received by October 31,
2013. Requests to speak and outlines of topics to be discussed at
the public hearing scheduled for December 9, 2013, at 10 a.m., must
be received by October 31, 2013.

FOR FURTHER INFORMATION CONTACT:

Concerning the proposed regulation, Julanne Allen at (202) 622-3920;
concerning submissions of comments, the public hearing, and/or to
be placed on the building access list to attend the public hearing,
Oluwafunmilayo (Funmi) Taylor at (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

This document contains proposed amendments to the Income Tax
Regulations (26 CFR part 1) relating to the application of the “controlled
group” rules found in section 851(c) of the Internal Revenue
Code of 1986, as amended (Code).

Section 851(b)(3)(B) provides that, to qualify as a RIC, a taxpayer
must meet an asset diversification test pursuant to which not more
than 25 percent of the value of the taxpayer’s total assets
may be invested in (i) the securities (other than Government securities
or the securities of other regulated investment companies) of any
one issuer, (ii) the securities (other than the securities of other
regulated investment companies) of two or more issuers which the taxpayer
controls and which are determined, under regulations prescribed by
the Secretary, to be engaged in the same or similar trades or businesses
or related trades or businesses, or (iii) the securities of one or
more qualified publicly traded partnerships (as defined in section
851(h)).

The controlled group rules in section 851(c) provide that, when
ascertaining the value of a taxpayer’s investment in the securities
of a particular issuer for purposes of determining whether the asset
diversification test has been met, the proportion of any investment
in the securities of such issuer by a member of the taxpayer’s
“controlled group” should be aggregated with the taxpayer’s
investment in such issuer, as determined under regulations. Section
851(c)(3) defines a controlled group as one or more chains of corporations
connected through stock ownership with the taxpayer if—(i) 20
percent or more of the total combined voting power of all classes
of stock entitled to vote of each of the corporations (except the
taxpayer) is owned directly by one or more of the other corporations;
and (ii) the taxpayer owns directly at least 20 percent or more of
the total combined voting power of all classes of stock entitled to
vote of at least one of the other corporations. Clarification is
needed regarding whether a RIC and its controlled subsidiary are a
controlled group if the subsidiary does not control (within the meaning
of section 851(c)(2)) at least one other corporation.

The definition of a controlled group for purposes of the RIC
rules was first enacted in 1942 and appears to have been modeled on
the definition of an “affiliated group” in the predecessor
to current section 1504(a). The predecessor to current section 1504(a)
used language nearly identical, save for different ownership thresholds,
to the definition of controlled group for purposes of the RIC rules.
See HR Rep. No. 2333, 77th Cong., 2nd Sess. 122 (1942), 1942-2 C.B.
372, 462-63; seealso The
Revenue Act of 1928, ch. 852, sec. 141(d), 45 Stat. 791, 831 (1928)
(enacting the predecessor to section 1504(a)). The current regulations
under section 851 include a series of examples, two of which reproduce,
nearly verbatim, examples contained in the 1942 legislative history.
See §1.851-5, Examples 3 and 4. Some practitioners have interpreted section 851(c)(3)
to require the presence of two levels of controlled entities for a
controlled group to exist, and have relied on certain of the examples
in the regulations, and the 1942 legislative history, to support this
interpretation. The IRS and the Treasury Department believe that
this interpretation is unwarranted. Accordingly, through revisions
to the existing examples, these proposed regulations clarify that
two corporations constitute a controlled group if the ownership requirements
of section 851(c)(3) are met.

The IRS and the Treasury Department believe that the interpretation
of the controlled group rules reflected in these proposed regulations
is consistent both with the statutory language of section 851(c)(3)
and the interpretation of analogous Code provisions. For example,
for purposes of the consolidated return rules, the IRS has consistently
treated a parent and its directly owned subsidiary as “affiliated”
within the meaning of section 1504(a)(1) regardless of whether the
subsidiary controlled another subsidiary. Likewise, in limiting certain
tax benefits for affiliated corporations, the IRS treats a parent
and its subsidiary as a “controlled group” under section
1563, which uses language similar to section 1504(a), regardless of
whether the subsidiary controls another entity. See section 1563(a)(1) and §1.1563-1(a)(2)(ii), Example 1. The
interpretation reflected in these proposed regulations is also consistent
with the purpose of section 851(c)(3), which is to aggregate the investments
of related corporations for purposes of the asset diversification
test.

The IRS and the Treasury Department believe that the language
in the examples in the existing regulations and in the 1942 legislative
history was intended merely to simplify the description of certain
fact patterns, and not to articulate a legal interpretation that is
inconsistent with the construction of substantially similar language
elsewhere in the Code and that is unsupported by practical or policy
considerations grounded in the statutory scheme.

Explanation of Provisions

The proposed regulations update examples in existing §1.851-5.
The controlled group rules of section 851(c) prevent a RIC from exceeding
the limitations set forth in section 851(b)(3) by indirectly investing
in the securities of an issuer through a subsidiary. This update
clarifies the controlled group rules and confirms that they are applied
in a manner consistent with sections 1504 and 1563.

First, the proposed changes to the regulations clarify the two
examples that have caused confusion. In Example 1, additional language
would clarify which entities in the example are members of a controlled
group. Currently, the example states that none of the subsidiaries
of the RIC in the example is a member of a controlled group. The
IRS and the Treasury Department believe that this statement was intended
merely to indicate that none of the wholly owned subsidiaries in the
example controlled another subsidiary. Consistent with the statutory
language of section 851(c)(3), the proposed regulations would clarify
that each of the RIC’s wholly owned subsidiaries is a member
of a controlled group with the RIC.

Example 4, which is derived from the legislative
history of section 851(c)(3), is revised to remove references to ownership
by controlled group members of greater than 20 percent interests in
an issuer. The existing language has sometimes been misinterpreted
to mean that in order for a subsidiary’s holdings in an issuer
to be aggregated with the holdings of the parent RIC, the subsidiary
must have a controlling interest in the issuer. The proposed revision
to Example 4 would ensure that Example 4 is applied in a manner consistent
with the statutory language of section 851(c)(3).

Second, the proposed changes would add a new example to illustrate
both the mechanics of the controlled group rules as applied to wholly
owned subsidiaries and the application of section 851(b)(3)(B)(iii)’s
rule with respect to securities of qualified publicly traded partnerships.

Third, the proposed changes would update the dates used in the
examples (1955) to the current year (2013 or 2014, where appropriate)
and would update references from section 851(b)(4) to refer instead
to section 851(b)(3). Section 1271(b)(1) of The Taxpayer Relief Act
of 1997, Public Law 105-34 (111 Stat. 788, 1063 (1997)), redesignated
section 851(b)(4) as section 851(b)(3).

Finally, for additional clarity, these proposed regulations
would add citations to section 851(d)(1) in Examples 5 and 6.

Proposed Effective Date

The proposed changes apply to quarters that begin at least 90
days after the date of publication in the Federal
Register of a Treasury decision adopting these rules as
final regulations.

Special Analyses

It has been determined that this notice of proposed rulemaking
is not a significant regulatory action as defined in Executive Order
12866, as supplemented by Executive Order 13563. Therefore, a regulatory
assessment is not required. It also has been determined that section
553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does
not apply to this regulation, and because the regulation does not
impose a collection of information on small entitles, the Regulatory
Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to
section 7805(f) of the Code, this notice of proposed rulemaking has
been submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.

Comments and Public Hearing

Before this proposed regulation is adopted as a final regulation,
consideration will be given to any written (a signed original and
eight (8) copies) or electronic comments that are submitted to the
IRS. The IRS and the Treasury Department request comments on all
aspects of the proposed examples. All comments will be available
for public inspection and copying.

A public hearing has been scheduled for December 9, 2013, beginning
at 10:00 a.m. in the IRS Auditorium, Internal Revenue Service, 1111
Constitution Avenue, N.W., Washington, DC 20224. Due to building
security procedures, visitors must enter at the Constitution Avenue
entrance. In addition, all visitors must present photo identification
to enter the building. Because of access restrictions, visitors will
not be admitted beyond the immediate entrance area more than 15 minutes
before the hearing starts. For information about having your name
placed on the building access list to attend the hearing, see the
“FOR FURTHER INFORMATION CONTACT” section of this preamble.

The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons
who wish to present oral comments at the hearing must submit written
or electronic comments by October 31, 2013 and an outline of the topics
to be discussed and the time to be devoted to each topic (signed original
and eight (8) copies) by October 31, 2013. A period of 10 minutes
will be allotted to each person for making comments. An agenda showing
the scheduling of the speakers will be prepared after the deadline
for receiving outlines has passed. Copies of the agenda will be available
free of charge at the hearing.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation for part 1 is amended by
adding an entry in numerical order to read in part as follows:

Authority: 26 U.S.C. 7805 * * *

Section 1.851-5 also issued under 26 U.S.C. 851(c)

Par. 2. Section 1.851-5 is revised to read as follows:

§1.851—5 Examples.—The
provisions of section 851 may be illustrated by the following examples:

(a) Example 1. Investment Company W at
the close of its first quarter of its taxable year has its assets
invested as follows:

Percent

Cash

5

Government securities

10

Securities of regulated investment companies

20

Securities of Corporation A

10

Securities of Corporation B

15

Securities of Corporation C

20

Securities of various corporations (not exceeding 5 percent
of its assets in any one company)

20

Total

100

Investment Company W owns all of the voting stock of Corporations
A and B, 15 percent of the voting stock of Corporation C, and less
than 10 percent of the voting stock of regulated investment companies
and various other corporations. Neither Corporation A nor Corporation
B owns (i) 20 percent or more of the voting stock of any other corporation,
(ii) securities issued by Corporation C, or (iii) securities issued
by any of the regulated investment companies or various corporations
whose securities are owned by Investment Company W. Except for Corporation
A and Corporation B, none of the corporations (including the regulated
investment companies) is a member of a controlled group with Investment
Company W.

Investment Company W meets the requirements under section 851(b)(3)
at the end of its first quarter. It complies with subparagraph (A)
of section 851(b)(3) because it has 55 percent of its assets invested
as provided in that subparagraph. It complies with subparagraph (B)
of section 851(b)(3) because it does not have more than 25 percent
of its assets invested in the securities of any one issuer, of two
or more issuers that it controls, or of one or more qualified publicly
traded partnerships (as defined in section 851(h)).

Example 2. Investment Company V at the
close of a particular quarter of the taxable year has its assets invested
as follows:

Percent

Cash

10

Government securities

35

Securities of Corporation A

7

Securities of Corporation B

12

Securities of Corporation C

15

Securities of Corporation D

21

Total

100

Investment Company V fails to meet the requirements of subparagraph
(A) of section 851(b)(3) since its assets invested in Corporations
A, B, C, and D exceed in each case 5 percent of the value of the total
assets of the company at the close of the particular quarter.

Example 3. Investment Company X at the
close of the particular quarter of the taxable year has its assets
invested as follows:

Percent

Cash and Government securities

20

Securities of Corporation A

5

Securities of Corporation B

10

Securities of Corporation C

25

Securities of various corporations (not exceeding 5 percent
of its assets in any one company)

40

Total

100

Investment Company X owns more than 20 percent of the voting
power of Corporations B and C and less than 10 percent of the voting
power of all of the other corporations. Corporation B manufactures
radios and Corporation C acts as its distributor and also distributes
radios for other companies. Investment Company X fails to meet the
requirements of subparagraph (B) of section 851(b)(3) since it has
35 percent of its assets invested in the securities of two issuers
which it controls and which are engaged in related trades or businesses.

Example 4. Investment Company Y at the
close of a particular quarter of its taxable year has its assets invested
as follows:

Percent

Cash and Government securities

15

Securities of Corporation K (a regulated investment company)

30

Securities of Corporation A

10

Securities of Corporation B

20

Securities of various corporations (not exceeding 5 percent
of its assets in any one company)

25

Total

100

Corporation K has 20 percent of its assets invested in Corporation
L, and Corporation L has 40 percent of its assets invested in Corporation
B. Corporation A also has 30 percent of its assets invested in Corporation
B. Investment Company Y owns more than 20 percent of the voting power
of Corporations A and K. Corporation K owns more than 20 percent
of the voting power of Corporation L.

At the end of that quarter, Investment Company Y is disqualified
under subparagraph (B)(i) of section 851(b)(3) because, after applying
section 851(c)(1), more than 25 percent of the value of Investment
Company Y’s total assets is invested in the securities of Corporation
B. This result is shown by the following calculation:

Percent

Percentage of assets invested directly in Corporation B

20.0

Percentage invested through K and L (30% x 20% x 40%)

2.4

Percentage invested indirectly through A (10% x 30%)

3.0

Total percentage of assets of Investment Company Y invested
in Corporation B

25.4

Example 5. Investment Company Z, which
keeps its books and makes its returns on the basis of the calendar
year, at the close of the first quarter of 2013 meets the requirements
of section 851(b)(3) and has 20 percent of its assets invested in
Corporation A. Later during the taxable year it makes distributions
to its shareholders and because of such distributions, it finds at
the close of the taxable year that it has more than 25 percent of
its remaining assets invested in Corporation A. Investment Company
Z does not lose its status as a regulated investment company for the
taxable year 2013 because of such distributions, nor will it lose
its status as a regulated investment company for 2014 or any subsequent
year solely as a result of such distributions. See section 851(d)(1).

Example 6. Investment Company Q, which
keeps its books and makes its returns on the basis of a calendar year,
at the close of the first quarter of 2013, meets the requirements
of section 851(b)(3) and has 20 percent of its assets invested in
Corporation P. At the close of the taxable year 2013, it finds that
it has more than 25 percent of its assets invested in Corporation
P. This situation results entirely from fluctuations in the market
values of the securities in Investment Company Q’s portfolio
and is not due in whole or in part to the acquisition of any security
or other property. Corporation Q does not lose its status as a regulated
investment company for the taxable year 2013 because of such fluctuations
in the market values of the securities in its portfolio, nor will
it lose its status as a regulated investment company for 2014 or any
subsequent year solely as a result of such market value fluctuations.
See section 851(d)(1).

Example 7. Investment Company T at the
close of a particular quarter of its taxable year has its assets invested
as follows:

Percent

Cash and Government securities

40

Securities of Corporation A

20

Securities of various qualified publicly traded partnerships
(within the meaning of sections 851(b)(3) and 851(h))

15

Securities of various corporations (not exceeding 5 percent
of its assets in any one company)

25

Total

100

Investment Company T owns more than 20 percent of the voting
power of Corporation A and less than 10 percent of the voting power
of all of the other corporations. Corporation A has 80 percent of
its assets invested in qualified publicly traded partnerships.

Investment Company T is disqualified under subparagraph (B)(iii)
of section 851(b)(3), because, after applying section 851(c)(1), more
than 25 percent of the value of Investment Company T’s total
assets is invested in the securities of one or more qualified publicly
traded partnerships. This result is shown by the following calculation:

Total percentage of assets of Investment Company T invested
in qualified publicly traded partnerships

31.0

(b) Effective/applicability date. The
proposed revisions apply to quarters that begin at least 90 days after
the date of publication of the Treasury decision adopting these rules
as a final regulation in the Federal Register.

Beth Tucker, Deputy Commissioner for Operations Support.

Note

(Filed by the Office of the Federal Register on August 1, 2013,
8:45 a.m., and published in the issue of the Federal Register for
August 2, 2013, 78 F.R. 46851)

Drafting Information

The principal author of this notice is Julanne Allen of the
Office of Associate Chief Counsel (Financial Institutions & Products).
For further information regarding this notice contact Julanne Allen
at (202) 622-3920 (not a toll-free call).